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Why Does Momentum Investing Work?

Momentum investing is one of the most popular and profitable methods of investing in the stock market. When executed correctly, momentum investing strategies take advantage of visible market trends and high momentum indicators to try and beat classic long-term investments such as index ETFs.

But why does momentum investing work so well, and what can investors learn from it?

On an extremely simplistic level, we could just say that momentum investing flies in the face of traditional trading strategies that promote the classic “buy low, sell high” mantra. One way to look at the success of momentum investing is that it tries a radically different core approach, “buy winners, and sell losers.” In that way, traders are riding the tide of broad market shifts rather than betting on one particular stock performing well in a vacuum.

But there are no doubt better explanations and deeper reasons for why momentum stocks have been shown to outperform strategies like value investing.

To learn more about the momentum approach and identifying momentum stocks, check out How to Find Momentum Stocks.

Behavioral Rationale for Momentum Investing

The most likely cause for momentum investing’s outsized success is behavioral. In a nutshell, momentum investors seek to take advantage of behavioral biases that most traditional investors exhibit.

There are a few different schools of thought about which behavioral tendencies best explain the success of momentum investing.

Confirmation Bias

Some experts believe that confirmation bias can explain outcomes in momentum investing.

Most people are more finely attuned to success than failure, overlooking negative factors in favor of potential upside. Investors have been known to discount evidence that suggests that past decisions that they’ve made might not produce future returns. It’s easier for people to hold on to their decisions, even if real-world information is telling them that the decision might have been a mistake.

Supporters of this theory say that it explains why momentum can be seen on all corners of Wall Street, including trading in stocks, bonds, commodities, and currencies. A behavioral explanation also suggests that momentum investors can take advantage of an enduring anomaly for potentially high returns.

Improper Weighing of Investment Signals

Another theory for explaining price anomalies and price momentum is that investors often undervalue the importance of multiple small signals while overvaluing the importance of a single large signal. This can give the impression that one indicator is driving a particular trend when, in fact, there are multiple forces at play on an asset price.

Instead of continually updating their investment outlook, some investors will look for a single high-profile event or catalyst to signal a change in financial markets. This focus on single events discounts new information that may be material to asset prices. The momentum factor may persist because investors are slow to incorporate new or small signals into their portfolios.

Disposition Effect

A final explanation for the high performance of momentum investing in relatively short timeframes is the disposition effect. Most investors are known to feel the pain of losing money more viscerally than the joy of gains. Thus, instead of selling losing stocks and cutting their losses, investors are more likely to sell winning stocks, locking in their winnings before the asset class is able to rise to its maximum stock price.

Risk-Based Rationale for Momentum Investing

Another classic explanation for the momentum strategy anomaly is that buying high and selling higher is inherently riskier than value investing. [1]

Value investing by nature involves buying low-value, or undervalued, assets that are being largely ignored by the market and then waiting for them to mature, thereby gaining value. At a basic level, you’re making a long-term bet that your initial investigation of the asset was correct. Warren Buffett and others have proven the long-term profits possible through this tried-and-true approach.

Momentum investing is focused more on the short term and involves more volatility. Buying stocks that have momentum also means that you need to trade more capital than with value investing. In addition, buying an underperforming stock that you believe to be undervalued is almost always less expensive than buying a stock that’s on the rise.

Long-Term Performance of Momentum Investing

While momentum investing is primarily a trading strategy that plays out over a short to medium-term period, it also has provable long-term success. Given the right tools and strategies, momentum investing has the potential to outperform many other classic indexes. According to the MSCI Momentum Index, “the MSCI World Momentum Index has historically generated excess returns over the long run with a 3.17% annual return over the MSCI World Index since 1999 as represented above.” That’s a much higher rate of return.

It’s important to note that it wasn’t all smooth sailing since 1999. The crash of 2008 and The Great Recession were massive disruptions to the investing world. Momentum investing was still able to come out on top.

When Does Momentum Not Work?

There are certainly situations where momentum investing isn’t the best strategy. However, these situations are usually short-lived, and markets generally return to a status where momentum investing is profitable.

Using a momentum trading strategy over the long term can increase the severity of drawdowns that an investor may experience. This is often because you end up holding assets that get hit the hardest in a recession or market pullback. As with any type of investing, nothing is without risk.  

You can also be vulnerable to quick reversals that can give you false signals or decrease overall profitability. It’s important to remember that refining your momentum investing strategy and guidelines can decrease the risks of these problems.

The other perennial issue with momentum investing is the high initial costs of startup. Because momentum investing uses a lot of trades to stay within its guidelines and risk margins, the costs of making such trades can be high. It’s important to consider these costs when practicing momentum investing to limit unforeseen drags on performance.

Read 5 Momentum Investing Strategies to Consider to evaluate and backtest momentum strategies for your portfolio.

Active Momentum Trading with Composer

Momentum trading is one of the most popular strategies on Composer and with good reason. Our technology helps to keep you up to date on price movements that can indicate trends and help you identify signals amid market volatility. Composer’s backtester incorporates trading costs to evaluate how strategies perform. It’s one of the things we do best.

Because momentum investing is core to Composer’s capabilities, we’re able to help investors find a strategy that meets their goals or help them build their own. As you continue to navigate the world of investing, see what Composer can do for you. Check out Composer today.